BAC's claim that the housing crisis actually caused these mbs losses may actually be true in a historical, non-litigation sense. The prevailing meme at the time of these massive mbs securitizations was that as long as housing prices continued to go up, even blindly-underwritten mortgages would be repaid. The housing crisis certainly punctured that blind faith balloon.
However, there is the matter of those pesky representations and warranties (R/W) that BAC made to mortgage investors and mortgage insurer MBI in the securitization documents; the same BAC R/Ws that MBI alleges in its SJ that BAC materially breached with respect to over 56% on the mortgages in the securitization pools MBI insured. MBI goes on to assert that BAC cannot contest that it breached its R/Ws with respect to these mortgages.
BAC's initial attempt to shift the blame was based upon its loss causation theory. BAC argued that it could avoid liability on its R/W breaches in the securitization documents unless the damaged party could show that those R/W breaches, rather than the housing crisis, caused the losses incurred by MBI and mbs investors.
This initial attempt by BAC to shift the blame was denied by Justice Bransten in her summary judgment ruling on 1/3/12 regarding loss causation. She found that BAC could be held liable to MBI under the transaction documents if BAC's R/W breaches materially increased MBI's risk of loss. There was no need to show that the R/W breaches themselves caused the losses. She went further to hold that MBI could obtain recissionary damages (recovery for all its losses incurred in insuring the securitization pool, not just losses for loans that individually breached the R/Ws).
The rejection of this loss causation theory that would have permitted BAC to shift the blame has since been seconded by two influential federal district court judges (Crotty and Rakoff) in similar mbs insurance cases.
Now, BAC seeks to shift the blame once again under another theory, by alleging that it can't be held liable to MBI for losses if MBI was aware (or should have been aware) of BAC's many breaches of R/Ws. BAC argues that MBI was put on notice of BAC's R/W breaches by virtue of the results of third party due diligence reports (conducted by firms retained by underwriters in connection with the offering of the mbs securities). BAC adds that it provided MBI digital records of the mortgage loans (mortgage tapes), and their contents should have put MBI on notice of BAC's R/W breaches.
Moreover, even though BAC cannot argue that its R/W breaches did not cause MBI's losses, it can still try to show at trial that its R/W breaches did not materially increase MBI's risk of loss.
The question now presented to Justice Bransten is whether BAC will prevail in its second attempt to shift the blame. Interestingly, Judge Rakoff's recent evidentiary holding in the now current trial of Assured Guaranty v Flagstar may provide ample insight into how this might play out before Justice Bransten.
It is important in assessing the merit of BAC's argument regarding MBI's unjustifiable reliance by distinguishing between the two principal claims presented by MBI: fraud and breach of R/W. BAC's notice and unreasonable reliance argument is applicable to the fraud claim, but it is not applicable to the breach of R/W claim.
The important distinction here is that the fraud claim is based upon a whole host of BAC conduct and communications (including BAC's breaches of its R/Ws). If BAC is able to show that MBI knew of BAC's fraud, then MBI was not justified in relying upon BAC's conduct and communications. Fraud is a "they misled us" theory of liability, and BAC's argument is that MBI could not have been misled if it knew the truth about the state of affairs regarding the BAC securitizations.
On the other hand, when BAC made express R/Ws in the transaction documents, the purpose of these R/Ws was not to communicate information but rather to allocate risk of loss in the event thse R/Ws were not true. The purpose of MBI insisting on the presence of these express R/Ws was to make clear that BAC incurred that risk of loss...irrespective of whether MBI knew or did not know of the truth or falsity of the R/Ws. In other words, express R/Ws serve the function of making clear that BAC was going to be on the hook even if it could be shown that the truth of the R/Ws was in doubt.
This distinction was relied upon by Justice Kornreich in a recent decision involving MBIA v Credit Suisse (10/13/2011), where she stated "[t]he fact that MBIA received certain contractual representations and warranties from DLJ...only supports the conclusion that MBIA resonably relied on this representation for purposes of an action for breach of express warranty. However, it does not change the analysis of MBIA's reliance for purposes of a tort action based on fraud or misrepresentation...By contrast, in warranty reliance, the critical question is not whether the [plaintiff] believed in the truth of the warranted information...but whether it believed it was purchasing the [defendant's] promise as to its truth" (emphasis in original).
Justice Kornreich declined to dismiss MBI's fraud claim on the papers, noting that the question of MBI's justifiable reliance in a fraud claim is fact-intensive and must await trial determination.
On this very point, a recent New York Court of Appeals case, DDJ Mnagement, LLC v Rhone Group, LLC (2010) makes it clear that mere whispers and hints that a defendant's representations may be false are not determinative against a plaintiff claiming fraud.
The highest NY court stated "[w]here, however, a plaintiff has taken reasonable steps to protect itself against deception, it should not be denied recovery merely because hindsight suggests that it might have been possible to detect the fraud when it occurred. In particular, where a plaintiff has gone to the trouble to insist on a written representation that certain facts are true, it will often be justified in accepting that representation rather than making its own inquiry. Indeed, there are many cases in which the plaintiff's failure to obtain a specific, written representation is given as a reason for finding reliance to be unjustified."
These words should give pause to bank mbs defendants seeking to show that plaintiff reliance in a fraud claim was unjustifiable, as it implies that plaintiffs can show justifiable reliance on defendant statements for purpose of a fraud claim, in part, by obtaining express R/Ws to the effect that the statements are true (thereby not only bolstering the fraud claim but also creating a separate and additional breach of R/W claim).
So how will BAC seek to shift the blame with respect to MBI's breach of R/W claim if it can only seek to assert unjustifiable reliance on the separate MBI fraud claim?
It is instructive to observe the arguments presented by trial counsel for Flagstar in its defense against Assured Guaranty in the now current bench trial in front of Judge Rakoff in New York. In this case, Judge Rakoff issued a summary judgment regarding loss causation that tracked Justice Bransten's earlier decision, holding that Assured Guaranty need show only that Flagstar's R/W breaches materially increased Assured Guaranty's risk of loss, not that they actually caused Assured Guaranty's losses.
On the second day of trial, October 11, 2012, Flagstar counsel elicited testimony from Assured Guaranty's witness regarding Assured Guaranty's loss modelling, in order to show that Assured Guaranty made erroneous assumptions regarding future losses in connection with the structuring of the securitization. Assured Guaranty averaged three loss models having 3%, 4% and 10% expected losses, instead of using what Flagstar claimed was the more appropriate 10% loss model.
Flagstar's argument was that if Assured Guaranty had used the proper loss model (10% expected loss), Assured Guaranty would not have suffered any losses in the securitization, breach or no breach of R/Ws. Hence, how could Flagstar's R/W breaches materially increase Assured Guaranty's risk of loss if the use of a proper securitization structure based on a proper loss model would have resulted in no losses!
Interestingly, this appears to be a backhanded way of reintroducing the housing crisis as a causal theory into the litigation, notwithstanding that it had been ruled not relevant to proving Assured Guaranty's case. Because after all, why would a 10% loss model be more appropriate for Assured Guaranty to use than an average of models that produced a lesser expected loss unless you point to the housing crisis as an ex post explanation for the losses.
Judge Rakoff would have none of this. In part, he stated: "But, but, but -- so if I'm insuring your herd of cows and I know that a healthy cow lives five years, and you represent to me that these are were all healthy cows, and I figure okay, you're asking for 10 years, I know a certain experience of percentage of these are likely to drop during that period and be made into steak, hamburger or television ads, that's fine. But I am not insuring, I am not calculating risk for a herd of cows having mad cow disease which you failed to reveal to me. If I had known that, my total calculation would have been entirely different. So I don't understand what the calculations that they made based on the representations and warranties that they were expecting to receive has anything to do with the situation where the representations and warranties are not true."
So Judge Rakoff allowed this testimony regarding loss modelling to be introduced by way of background, but not for the purpose of proving that Flagstar's R/W breaches were not material. Trials always offer unexpected turns, but one may expect that if BAC presents testimony along these lines in a trial with MBI in seeking to show that BAC's R/W breaches were not material, Justice Bransten will follow Judge Rakoff's analysis.
NB: this blog is not intended to be investment advice, and should not be relied upon by anyone to constitute investment advice. Investing is a tough game, and everyone must do and own their own work, because you will certainly own your investments.
Disclosure: long MBI. Follow me on twitter.